Weekly Small Cap Market Review: May 8 – May 12

I had a unique honor to be on Bloomberg radio last week to discuss the small cap market and some stock ideas from the AdvisorShares Cornerstone Small Cap ETF. I guess it was fate – I’ve always been told I had a face for radio. We discussed current valuations in the small cap market, and thought it would be helpful to share that here.

The incredible run in small cap stocks since the election has led to high valuations, with the Russell 2000 trading at 14x trailing EBITDA, a level not seen since 2003. Much of the small cap run since the election has been driven by expectations rather than actual proven results, as small caps are advantaged from the Trump trade, with domestic exposure, high tax rates, and regulatory burdens. However, high valuations put the weight of earnings growth on companies themselves, and that growth hasn’t yet been proven. So this quarter’s results and next quarter’s results will be important to see if companies can demonstrate the inflection in earnings needed to justify their valuations. With strong underlying performance, we believe companies that continue to demonstrate fundamental performance improvement, supported by quality balance sheets, should continue to be attractive opportunities.

The small cap market, as defined by the Russell 2000 Index, was down 1.0% overall during the week. Markets were generally lower during the week, with some positives (inflation stabilizing, jobless claims down) and negatives (retail weakness). In Washington, President Trump’s firing of FBI director James Comey on Tuesday afternoon caught people by surprise on both sides of the aisle, which may add some uncertainty to the broader political and legislative environment. However, volatility remains low, as sentiment is positive and quarterly earnings growth (at least outside of the dismal retail sector) have been strong. IT (+1.1%, semiconductors and equipment), Energy (+0.4%, as oil prices were up), and Health Care (+0.2%) were the strongest sectors in the Index. Financials (-2.3%, from banks) and Industrials (-2.3%) were the weakest. In total, small caps underperformed large caps, as the Russell 2000 Index returned around 65 basis points less than the Russell 1000 Index (down 0.3%). Among small caps, growth continues to outperform, with the Russell 2000 Growth Index beating the Russell 2000 Value Index by approximately 100 basis points.

There has been a lot of progress in small cap earnings season, with about 85% of the index reporting so far. Companies performed in line with historical levels, with about 60-65% beating Wall Street estimates on the top-line and bottom line. Revenue growth is expected to improve, with a 1% increase in expectations for Q2, but earnings estimates actually came down slightly for Q2.

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